In a mortgage, the homeowner/borrower makes a monthly payment to the lender. After each payment, the equity in the home increases and at the end of the mortgage term (for example, 15 or 30 years), the mortgage is paid in full and the property is transferred from the lender to the borrower. In contrast, in a reverse mortgage, the homeowner receives a loan (for example, an upfront payment or monthly payments) which accrues interest. Each payment to the borrower increases the debt on the property, which the borrower pays off using the proceeds of the future home sale.
In a reverse mortgage, the amount of the loan the borrower receives depends upon the borrower's age, Federal Housing Administration or Fannie Mae appraised value of the home, and the interest rate at the closing. Reverse mortgage loans provide a lump sum, credit line, or monthly payments to borrowers. The loans are secured against a first mortgage deed on the home. Unlike traditional mortgage loans, current interest or principal payments are not required and the credit quality of the borrower, as measured, for example, by a FICO score, is not relevant to underwriting of the loan. The loan is asset-based only, i.e., secured non-recourse against the property. Interest accrues and is compounded at the loan rate. As the debt balance grows, the loan to value (LTV) ratio typically increases over time, with the expectation that the last borrower will either move, die, or vacate the home for a period longer than 12 months before the LTV ratio exceeds one, at which point the lender begins to suffer losses.
The reverse mortgage loan amount is not taxable because the IRS does not consider loan advances to be income. The reverse mortgage ends when the homeowner dies, sells the home, or moves out of the house for 12 consecutive months. At that time, the reverse mortgage loan amount can be paid off with the proceeds of the home sale. Alternatively, heirs of the borrower can refinance the reverse mortgage. If the proceeds of the home sale exceed the loan amount, the homeowner receives the difference. On the other hand, if the proceeds of the home sale are insufficient to pay off the loan, the lender (or loan insurer) absorbs the difference. For the latter, the cap on the debt is called the non-recourse limit, and it means that the lender has no legal recourse to receive anything more than the value of the home when the reverse mortgage is paid off.
The reverse mortgage market is growing at over a 50% rate per annum as of 2007. The market is segmented into loans against homes with values less than approximately $400,000 and those above. For the former, borrowers are typically issued a Federal Housing Administration (FHA) insured Home Equity Conversion Mortgage or HECM. As of 2007, the loan rate for HECM's was 150 basis points over the constant maturity one year treasury bill, which includes 50 basis points of FHA insurance and which enables lenders to sell their loans to the FHA upon the loans attaining a 98% LTV ratio. For non-HECM or proprietary loans, the average rate as of 2007 was approximately 3 month London Inter-bank Offered Rate (LIBOR)+350 basis points. The amount of lump sum advance or credit line is determined by the principal limit factor or PLF. The PLF is a function of interest rates, assumed future housing price appreciation (HPA), and the mortality, morbidity, and mobility (MMM) of the borrower or borrowers. Typically, the older the borrower the higher the PLF and the greater amount of proceeds that the borrower can receive. Furthermore, the greater the expected morbidity and mobility or the borrower the greater the amount of proceeds the borrower can receive. For the LIBOR+350 product, a 70 year old female who owns a house appraised at $1 million, can expect to receive approximately $400,000 (as of 2007) in proceeds. The undrawn portion of the credit line increases with the loan rate in typical proprietary products.
For example, a 70-year-old borrower who receives $400,000 on a $1 million home in a proprietary reverse mortgage loan will have a debt balance at years 5, 10, 15, 20, and 25 as follows:
YearDebt Balance5$615,45010$946,94515$1,456,99320$2,241,76425$3,449,232
If the home value has not appreciated, then the debt balance exceeds the home value by over $450,000 at year 15, by over $1.24 million at year 20, and by over $2.449 million at year 25.
The reverse mortgage industry to date has failed to understand the implications to the borrower and the lender when the mortgage debt is not in balance with the home value throughout and at the end of the reverse mortgage term. For example, many lenders tout to their borrowers that reverse mortgages can provide “tax-free income.” Indeed, a well-known book on reverse mortgages by Tom Kelly entitled, “The New Reverse Mortgage Formula: How to Convert Home Equity into Tax-Free Income,” describes the so-called advantages of reverse mortgages. Although a reverse mortgage loan is not characterized as income under the Tax Code and therefore cannot be taxable, labeling a reverse mortgage loan as “tax-free income” belies the sophistication of the market with regard to tax matters.
Unfortunately, state of the art reverse mortgage loans reflect a more serious disregard by reverse mortgage lenders to appreciate the correct tax consequences of their loans. In particular, it is common for reverse mortgage lenders to characterize or tout the non-recourse nature of a reverse mortgage loan as a “heads borrower wins, tails lender loses” proposition. Lenders have designed their products with this assumption in mind with the consequence that the loan rate, the PLF, and whether the loan is fixed or variable, among other factors, will have a high probability in forcing a significant number of loans into default. However, the assumption that this default is costless to the borrower because reverse mortgage loans are “non-recourse” is false.
Current state of the art mortgage products do not address the serious tax consequence that can arise as the reverse mortgage debt balance rises above the mortgaged home's value. The tax consequences are best illustrated with the examples below based on the following assumptions: 1) Borrower's basis in home: $100,000; 2) Home's current value: $1,000,000; 3) Reverse mortgage proceeds: $400,000; 4) Reverse mortgage not original acquisition indebtedness; 5) Internal Revenue Code (IRC) section 121 requirements met; and 6) At death of Borrower: i) Outstanding loan balance is $2,000,000; and ii) Fair market value (FMV) of home is $1,000,000.
Example 1: If borrower is sole owner of property and dies before Dec. 31, 2009 or after Jan. 1, 2011 and a sale of the home takes place where debt balance is greater than FMV, the following is the tax consequence: i) Basis of property: step-up in basis to $1,000,000; ii) Gain: $1,000,000 (equal to debt balance of $2,000,000 minus $1,000,000 FMV); iii) Home equity deductions: $400,000 (accrued interest on $100,000 of the $400,000 mortgage); iv) Taxable Gain: $600,000; v) Federal Tax: $90,000 (15% capital gains rate on Taxable Gain); and vi) Who pays: a) if borrower left a will, the Executor pays out of estate assets; b) if borrower bequeathed property to individual, the individual is liable and should consider disclaiming his interest; and c) if borrower died intestate, Administrator pays out of estate assets.
A less likely scenario is the surviving spouse moving out of the home (e.g., into a nursing home) as shown in the following example. Scenario 2: First spouse dies after Jan. 1, 2011 and surviving spouse moves into nursing home or otherwise leaves home: i) Basis in property stepped up partially to $550,000; ii) Gain on sale=$1,450,000 ($2,000,000 debt balance−$550,000); iii) Home equity deductions: $400,000; iv) IRC section 121 Exclusion to surviving spouse: a) $500,000 if sale is in year of first spouse's death and joint return is filed; and b) $250,000 if sale is in a year after year of first spouse's death or if joint return is not filed; v) Taxable gain assuming sale more than a year after first spouse death: i) Taxable Gain=$1,450,000−$400,000−$250,000=$800,000; and vi) Federal Tax=$120,000 (15% capital gains rate on Taxable Gain).
As can be seen from the above scenarios, the borrower can be burdened with debt forgiveness taxation upon sale of the home when the debt balance exceeds the home value. The reverse mortgage industry is in a nascent state and is generally unsophisticated in tax matters and no loans have yet produced the above results. But the current state of the art loans will, given enough time, produce these adverse outcomes and borrowers will suffer financially. Lenders may also face legal and regulatory action by not disclosing these possible adverse outcomes to borrowers.